Updated 11/10/2008

For all those financial company bears in the market place, there’s an old regulator’s tool, born in the wild west during the 80’s which might shed some light on the health of banks large and small:

The Texas Ratio

definition: Non performing Loans / ( Tangible net capital +Loan Loss Reserves)

Values: 0%-100% = Insolvent with 0% being better

Check out this marketwatch story on the Texas Ratio and this blogpost on the texas ratio by seeking alpha.

For the would be investors who are bargain hunting financial stocks, this is a great tool for evaluating the solvency on a current and historical basis of the institutions that you are targeting. It also explains how lenders that indulged in too many option arms are suffering.

To recap, book a loan whose payments are 65% of the total income, report the 35% that you don’t get paid in monthly interested, but add to the balance as PROFITS. Use these loans to expand your balance sheet continuously, and keep adding more income by writing paper, but not actually collecting all of your profits, per se. Close new loan and repeat.

If you read this blog back in 2006 and noticed that Option ARMs tend to have problems with payment shock, one might imagine that these loans would certainly be candidates for default considering they were given with 3 year prepayment penalties and to borrowers who didn’t document income . . . When home prices are eternally rising I guess there’s always someone else to re-option the property, but these call options are coming due and the buyers (current homeowners) are probably not going to be able to make due with a 255% monthly payment increase, especially, if the option loan blew their property value out of proportion.

The primary lenders for thse products such as IndyMac Bank IMB, Wachovia WB, Washington Mutual Bank IMB and BankUnited BKUNA are now being punished by the market is that their option arm portfolios growth makes them highly susceptible to requiring excess amounts of new capital as swollen Option ARM loans move in the the non-performing asset categories and requiring larger loan loss reserves which are eating current profits as well as threatening shareholders’ equity. Countrywide Financial now owned wholly by Bank of America also has many of these loans, but mostly held off balance sheet through reps and warranties to the investors who bought the loans.

Now these options arms must be unwound from the banks’ balance sheets and they are a perfect storm. Inflated loan losses that must be written off against current earnings, requiring greater reserves of capital with smaller dividends, which causes the stock value to crash meaning that institutions wipe out current shareholders and invite new ones at depressed prices. . . . . .

And Texas? Their residential real estate market is pretty stable right now! They have special state restrictions on cash out from real estate equity and 2nd lending, go figure . . .

UPDATE: 11/10/2008 – Go figure, Wachovia and Washinton Mutual have failed, the market applied a Texas ratio to them and within a few years, they will be forgotten institutions thanks to their poor risk management(WaMu) and ill advised merger activity (Wachovia)